Monday, May 28, 2007

An opening on Finance and Investing

In reply to:

Jonathan says:

"but I don't see any evidence that investing skill has the same permanence as
poker skill"

OK, clearly there are two issues at play here.

  1. By pure stats, a certain percentage of people will end up on either end of the win/loss scale in a zero-sum game. Now, winning poker players are playing a game of "incomplete information" (not unlike the markets). These players are winning b/c they are making the "correct call" more often than the opponent(s). Now it could be argued that the "correct calls" are actually dictated by chance. I mean, somebody's got to make a decision and if you give enough people the opportunity to make the decision *someone* will make more correct decisions. Johnathan is saying that poker and investing are different b/c poker players demonstrate skill at making the right calls and investors don't. But he's not really backing that up.
  2. "Permanence", Johnathan is trying to undermine the "zero-sum game theory" by inserting the term *permanence*. And this is where he wins (kind of). You see, "good poker strategy" is more or less static. So poker players can evolve their strategy by learning the basics (don't fold pocket Aces pre-flop) and then tweaking the details (tighter/looser, more or less aggressive, calling/reading specific players). But markets are not this simple, the "rules" and strategies are constantly evolving. Trying to find permanence in investing skill is inherently complex b/c "investment" is inherently complex. I mean, "investing" in/of itself is really a meta-game of games and the investment "game" spans lifetimes.

Point is poker and investment are variants on the same game. So if there can be "poker skill", there must be "investing skill". Just b/c the investment game has more layers doesn't mean that it's suddenly lucky, it just means that it's a lot harder to learn.

To understand permanence, take a look at the very vein of discussion in the link above. Lots of talk of mutual funds and how indexing is better. This is based on the "Random Walk Down Wall Street" concept, which basically found that the distribution of indexes vs mutual funds was the same, except that mutual funds performed worse by about a factor of their management fees. So if you just wanted to make money on stock (equity) trading, then you might as well index b/c the average money manager is costing you 1%.

Of course, this is only true b/c of the ubiquity of mutual funds. There was a time when investing in a mutual fund was actually an edge not a liability, but not today. Today, the investors on Johnathan's board are trying to find a 1-2% edge by indexing instead of using mutual funds. But if 60% of the market starts indexing, then this strategy stops working.

And so that's kind of my point, you can't have permanence in the markets, because the markets are not permanent. Yesterday's great move is just tomorrow's status quo.

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